An Economic Analysis Of Investment In The United States Shipbuilding Industry

NAVAL POSTGRADUATE SCHOOL MONTEREY, CALIFORNIA THESIS AN ECONOMIC ANALYSIS OF INVESTMENT IN THE UNITED STATES SHIPBUILDING INDUSTRY by Nicholas A Meyers June 2010 Thesis Co-Advisors: Daniel A Nussbaum Joseph G San Miguel Approved for public release; distribution is unlimited THIS PAGE INTENTIONALLY LEFT BLANK REPORT DOCUMENTATION PAGE Form Approved OMB No 0704-0188 Public reporting burden for this collection of information is estimated to average hour per response, including the time for reviewing instruction, searching existing data sources, gathering and maintaining the data needed, and completing and reviewing the collection of information Send comments regarding this burden estimate or any other aspect of this collection of information, including suggestions for reducing this burden, to Washington headquarters Services, Directorate for Information Operations and Reports, 1215 Jefferson Davis Highway, Suite 1204, Arlington, VA 22202-4302, and to the Office of Management and Budget, Paperwork Reduction Project (0704-0188) Washington DC 20503 AGENCY USE ONLY (Leave blank) REPORT DATE REPORT TYPE AND DATES COVERED June 2010 Master’s Thesis TITLE AND SUBTITLE An Economic Analysis of Investment in the United FUNDING NUMBERS States Shipbuilding Industry AUTHOR(S) Nicholas A Meyers PERFORMING ORGANIZATION NAME(S) AND ADDRESS(ES) PERFORMING ORGANIZATION Naval Postgraduate School REPORT NUMBER Monterey, CA 93943-5000 SPONSORING /MONITORING AGENCY NAME(S) AND ADDRESS(ES) 10 SPONSORING/MONITORING N/A AGENCY REPORT NUMBER 11 SUPPLEMENTARY NOTES The views expressed in this thesis are those of the author and not reflect the official policy or position of the Department of Defense or the U.S Government IRB Protocol number 12a DISTRIBUTION / AVAILABILITY STATEMENT Approved for public release; distribution is unlimited 12b DISTRIBUTION CODE 13 ABSTRACT (maximum 200 words) Amidst the global economic recession and sizeable injections of federal stimulus packages, the U.S Navy’s budget for ship construction has experienced only modest real growth While the 2010 Quadrennial Defense Review has reaffirmed a fleet size goal of 313 ships, some suggest that $20 billion or more per year is needed to attain this level of strategic resources This research has analyzed the United States’ shipbuilding industry as a potential source of economic stimulus using measures applied in the United Kingdom by economists at Oxford Economics First, monetary impacts from the “ship building and repairing” sector were analyzed using U.S Bureau of Economic Analysis (BEA) input/output data and the “Leontief inversion process” modeled at Carnegie Mellon University This sector was compared with five alternative investments Second, the benefits of the shipyard-related labor market were analyzed using data from the BEA and Naval Sea Systems Command Measures of capital intensity and capacity were then applied to companies representing five industries The results suggest that U.S shipbuilding generates monetary benefits comparable to alternatives, while supporting more labor than other sectors Finally, excess capacity shows a clear ability to absorb an increase in demand, providing prompt and positive impact on sustainable economic recovery 14 SUBJECT TERMS shipbuilding, economics, multiplier, investment, economic return, funding of alternative investments, use of taxpayer dollars, economic analysis, ships, lifecycle, manufacturing economic return, economic stimulus, stimulus, recession, Navy 17 SECURITY CLASSIFICATION OF REPORT Unclassified 18 SECURITY CLASSIFICATION OF THIS PAGE Unclassified NSN 7540-01-280-5500 15 NUMBER OF PAGES 99 16 PRICE CODE 19 SECURITY 20 LIMITATION OF CLASSIFICATION OF ABSTRACT ABSTRACT Unclassified UU Standard Form 298 (Rev 2-89) Prescribed by ANSI Std 239-18 i THIS PAGE INTENTIONALLY LEFT BLANK ii Approved for public release; distribution is unlimited AN ECONOMIC ANALYSIS OF INVESTMENT IN THE UNITED STATES SHIPBUILDING INDUSTRY Nicholas A Meyers Lieutenant, United States Navy B.S Cp.E., Virginia Polytechnic Institute and State University, 2002 Submitted in partial fulfillment of the requirements for the degree of MASTER OF BUSINESS ADMINISTRATION from the NAVAL POSTGRADUATE SCHOOL June 2010 Author: Nicholas A Meyers Approved by: Daniel A Nussbaum, PhD Thesis Co-Advisor Joseph G San Miguel, PhD Thesis Co-Advisor William Gates Dean, Graduate School of Business and Public Policy iii THIS PAGE INTENTIONALLY LEFT BLANK iv ABSTRACT Amidst the global economic recession and sizeable injections of federal stimulus packages, the U.S Navy’s budget for ship construction has experienced only modest real growth While the 2010 Quadrennial Defense Review has reaffirmed a fleet size goal of 313 ships, some suggest that $20 billion or more per year is needed to attain this level of strategic resources This research has analyzed the United States’ shipbuilding industry as a potential source of economic stimulus using measures applied in the United Kingdom by economists at Oxford Economics First, monetary impacts from the “ship building and repairing” sector were analyzed using U.S Bureau of Economic Analysis (BEA) input/output data and the “Leontief inversion process” modeled at Carnegie Mellon University This sector was compared with five alternative investments Second, the benefits of the shipyard-related labor market were analyzed using data from the BEA and Naval Sea Systems Command Measures of capital intensity and capacity were then applied to companies representing five industries The results suggest that U.S shipbuilding generates monetary benefits comparable to alternatives, while supporting more labor than other sectors Finally, excess capacity shows a clear ability to absorb an increase in demand, providing prompt and positive impact on sustainable economic recovery v THIS PAGE INTENTIONALLY LEFT BLANK vi TABLE OF CONTENTS I INTRODUCTION A PURPOSE OF STUDY B PROBLEM .3 Problem 1: U.S Navy Fleet Size: An Uncharted Goal .3 Problem 2: What Does Shipbuilding Do for the Economy? How? C SCOPE OF THESIS STUDY What Is Not Included, and Why? .6 How Shipbuilding Is Unique .6 II BACKGROUND A HISTORY B TODAY 10 The Navy’s Unique Role—Sea Control 11 Today’s United States Shipbuilding Industry 11 C OTHER NATIONS’ SHIP PROCUREMENT 12 D HOW SHIPS ARE ECONOMICALLY UNIQUE .13 III METHODOLOGY 15 A GENERAL APPROACH 15 B FREE MARKET CONCERNS 16 C MONETARY IMPACT: DIRECT, INDIRECT, INDUCED 17 Input/Output Analysis and Leontief Inversion .17 a Direct, Indirect, and Induced Impacts 19 Other Sectors Considered 20 Estimation of Induced Multipliers 20 Regional Distribution of Impacts and Employment .21 ABOR MARKET IMPACT 22 D Highly Skilled Jobs 22 Labor Trends 23 E CAPITAL INTENSITY, AND EXCESS CAPACITY—“WHAT IF”? 23 F CAPACITY MEASURES AND A RAPID RETURN? 25 IV RESULTS 27 A INPUT/OUPUT MULTIPLIER ANALYSIS 27 Direct Economic Effects 28 Value Added .29 Total Economic Effects 32 Induced Economic Effects .34 Multipliers: The “Bottom Line” for the Navy SCN Account 37 B LABOR MARKET IMPACT .39 Using the Carnegie Mellon EIO-LCA Model 39 Shipyard Direct Labor Trends 43 vii C D V RIMS Model’s Employment Multipliers by State 46 CAPITAL INTENSITY .49 CAPACITY MEASURES .52 Industrial Production by Industry 52 Capacity Utilization 55 SUMMARY, CONCLUSIONS, AND RECOMMENDATIONS 59 A SUMMARY OF FINDINGS 59 Monetary Impact .59 Labor Market Impact 60 Capital Intensity .62 Capacity Measures 62 B CONCLUSIONS 63 For the Shipbuilders 63 For the Navy .63 For Congress and the Secretariat 64 C RECOMMENDATIONS .65 Life Cycle Benefit .66 LIST OF REFERENCES 67 APPENDIX A: QUESTIONS LIST 73 APPENDIX B: FEDERAL RESERVE BOARD PROCEDURES 75 INITIAL DISTRIBUTION LIST 81 viii LIST OF REFERENCES American Shipbuilding Association (ASA) (2009) About ASA Washington, DC: American Shipbuilding Association American Shipbuilding Association (ASA) (2009, December 3) Unilateral Navy disarmament Washington, DC: American Shipbuilding Association Atesoglu, H.S (2005–6) Economic Consequences of a rise in defense spending after September 11, 2001 Journal of Post Keynesian Economics, 28(2), 181 Barnard, R.C (2005) Shipbuilding: An Uncertain Future Sea Power, 48(2), 28 Booth, W., Colomb, G.G., & Williams, J.M (2008) The craft of research Chicago: University of Chicago Press Bureau of Economic Analysis (BEA) (1997) Regional multipliers: A user handbook for the regional input-output modeling system (RIMS II) Washington, DC: U.S Department of Commerce, Economics and Statistics Administration Bureau of Economic Analysis (BEA) (2010, April) Industry economic accounts Retrieved February 5, 2010, from http://www.bea.gov/industry/io_benchmark.htm Bureau of Economic Analysis (BEA) (2009, November 24) Gross domestic product release [Electronic Version] Washington, DC: Bureau of Economic Analysis Bureau of Labor Statistics (BLS) (2009) Economy at a glance, United States Washington, DC: Bureau of Labor Statistics Bureau of Labor Statistics (BLS) (2010, March) Local area unemployment statistics Retrieved April 30, 2010, from http://www.bls.gov/lau/ Capital Intensity (n.d.) BusinessDictionary.com Retrieved April 4, 2010, from http://www.businessdictionary.com/definition/capital-intensity.html Carnegie Mellon University Green Design Institute (n.d.) U.S 2002 industry benchmark model Retrieved February 3, 2010, from Economic Input-Output Life Cycle Assessment (EIO-LCA) Web site: http://www.eiolca.net Carnegie Mellon University Green Design Institute (2008) Economic Input-Output Life Cycle Assessment (EIO-LCA), U.S 2002 Industry Benchmark model Retrieved January 30, 2010, from http://www.eiolca.net 67 Castelli, C (2009, December 7) Navy raises 313-ship goal to 324, boosts focus on missile defense Inside the Navy, p Department of Defense (DoD), United States of America (2010, February) Quadrennial Defense Review Washington, DC: Department of Defense Department of the Navy (DoN) (2008) Fiscal year 2009 budget estimates Washington, DC: Department of the Navy Department of the Navy (DoN) (2009) Fiscal year 2010 budget estimates Washington, DC: Department of the Navy Director, Warfare Integration (Office of the Chief of Naval Operations (OPNAV N8F) (2010) Report to Congress on annual long-range plan for construction of naval vessels for FY 2011 Washington, DC: Office of the Chief of Naval Operations Doehring, T., & Jenning, M (2009, December) Unofficial U.S Navy Site Retrieved March 25, 2010, from http://www.navysite.de/ships.htm Drake, R.L (1976) A short-cut to estimates of regional input-output multipliers International Regional Science Review, 1(1), 1–17 Drucker, P (1992) The age of discontinuity: Guidelines to our changing society Piscataway, NJ: Transaction Publishers Ericson, M., He, E., & Schoenfield, A (2009, June 24) Tracking the $700 billion bailout The New York Times, p B2 Federal Reserve Board (2010) Industrial Production and Capacity Utilization Retrieved May 18, 2010, from http://www.federalreserve.gov/Releases/g17/ Friedman, G (2009) The next 100 years New York: Doubleday Gamick, D.H (1970) Differential regional multiplier models Journal of Regional Science, 10 (1), 35–47 General Dynamics (2009) 2009 annual report Falls Church, VA: General Dynamics Hancock, R (2003) Underwater welding in nuclear power plants Welding Journal Retrieved March 28, 2010, from http://www.aws.org/wj/sept03/feature1.html Homan, T (2009, November 29) Job losses, manufacturing probably eased: U.S economy preview Retrieved December 11, 2009, from http://www.bloomberg.com/apps/news?pid=20601087&sid=aErIZXt7wkJs 68 Honolulu Advertiser (2010, February 10) Pearl Harbor shipyard completes USS Hawaii repairs Honolulu Advertiser, A5 Katz, J.L (1980) The relationship between type I and type II income multipliers in an input-output model International Regional Science Review, 51–56 Krugman, P (2009, January 13) Bang for the buck (wonkish) The New York Times, p A7 Law and Economics Consulting Group (LECG) (2002) The economic contribution of the U.S commercial shipbuilding industry Washington, DC: Shipbuilders Council of America Leontief, W (1966) Input-output economics New York: Oxford University Press Lim, D (2007) On the measurement of capital intensity Review of World Economics, 760–766 Lynch, T (2000, October) Analyzing the Economic Impact of Transportation Projects using RIMS II, IMPLAN, and REMI Tallahassee, Florida: Florida State University McGuire, M (2009) Integration of the naval unmanned combat aerial system into the future naval air wing Master’s thesis, Monterey, CA: Naval Postgraduate School McIntire, K (2009, September 16) Top admiral affirms commitment to 313-ship fleet Undersea Enterprise News Daily, p Miller, R.E., & Blair, P.D (1985) Input-output analysis: Foundations and extensions Englewood Cliffs, NJ: Prentice-Hall Mullen, A.M (2007,) Prepared testimony Testimony before the Defense Appropriation Subcommittee 110th Congress, 2nd Session Washington, DC: U.S Government Printing Office National Bureau of Statistics (NBS) of China (2009, October 10) GDP growth in China, 1959-2009 Retrieved February 3, 2010, from http://www.chinability.com/GDP.htm National Defense Research Institute (RAND) (2006) Why has the cost of Navy ships risen? Washington, DC: RAND Naval Historical Center (2002, January 23) U.S Navy active ship force levels, 1917 -today Retrieved December 15, 2009, from http://www.history.navy.mil/branches/org9-4.htm 69 NAVSEA Shipbuilding Support Office (2009, December 1) Fleet size Retrieved December 15, 2009, from http://www.nvr.navy.mil/nvrships/FLEET.HTM Northrop Grumman (NG) (2009) Shipbuilding fact sheet—Gulf Coast Pascagoula, MS: Author Office of Management and Budget (OMB) (2010) Analytical perspectives: Budget of the U.S government Washington, DC: Author O'Rourke, R (2009) Navy force structure and shipbuilding plans: Background and issues for Congress Washington, DC: Congressional Research Service Orszag, P.R (2009, February 3) Letter to Senate Majority Leader Harry Reid Washington, DC: Office of Management and Budget Oxford Economics (2004) The economic contribution of BAE systems to the UK and implications for defence procurement strategy London: Oxford Economic Forecasting Oxford Economics (2009) The economic case for investing in the UK defence industry London: Oxford Economics Pace, J., Taylor, A., & Elliott, P (2009, December 8) Obama urges major new stimulus, jobs spending The New York Times, p A1 Pershing, B (2010, March 18) Congress sends Obama $18 billion jobs bill to sign The Washington Post Recovery Accountability and Transparency Board (2009) The act Retrieved December 10, 2009, from http://www.recovery.gov/About/Pages/The_Act.aspx Redlick, R.J (2009, October 1) Stimulus spending doesn't work The Wall Street Journal, p C5 Samuelson, P A (1994) Richard Kahn: his welfare economics and lifetime achievement Cambridge Journal of Economics (18) 1, 55–72 Shulman, L (2008) The return of the cash cow Boston, MA: The Boston Consulting Group Steuerle, C.E (2004) Contemporary U.S tax policy Washington, DC: Urban Institute Press UK Office of National Statistics (2002, November 13) Guide to definitions Retrieved April 8, 2010, from http://www.statistics.gov.uk/cci/nugget.asp?ID=254 70 U.S Census Bureau (2010, January 14) North American industry classification system Retrieved February 5, 2010, from http://www.census.gov/eos/www/naics/ U.S Congress (2009, May 22) Weapons system reform act of 2009 (Public Law 11123) 111th Congress, 123 Statute 1704 Retrieved December 15, 2009, from http://www.gpo.gov/fdsys/pkg/PLAW-111publ23/pdf/PLAW-111publ23.pdf U.S Energy Information Administration (2008, January) World oil transit chokepoints Retrieved December 14, 2009, from http://www.eia.doe.gov/cabs/World_Oil_Transit_Chokepoints/ U.S Federal Reserve Board (2009, March 27) Capacity utilization explanatory notes Retrieved April 3, 2010, from http://www.federalreserve.gov/Releases/g17/cap_notes.htm U.S Federal Reserve Board (2010) Industry structure of industrial production: Classification, value-added weights, and description of series Washington, DC: U.S Federal Reserve Board U.S Navy (2010, May 18) Official Web site of U.S Navy Retrieved May 19, 2010, from Status of the Navy: http://www.navy.mil/navydata/navy_legacy_hr.asp?id=146 Walters, W (2000) Geographic record: American naval shipbuilding Geographic Review, 418–431 Wassily Leontief, et al (1976) Studies in the structure of the American economy White Plains, NY: International Arts and Sciences Press Work, R (2009) The U.S Navy: Charting a course for tomorrow's fleet Washington, DC: Center for Strategic and Budgetary Assessments World Bank (2009, October 7) World development indicators database Retrieved December 16, 2009, from http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP.pdf Wright, J., & Fields, M (2009) Shipyard economic impact study Washington, DC: Naval Sea Systems Command 71 THIS PAGE INTENTIONALLY LEFT BLANK 72 APPENDIX A: QUESTIONS LIST Goal: Consultation with interested and informed parties regarding data collection, past similar studies, and expected results (1) What do you think are the “unique” aspects of shipbuilding that allow it to provide  greater benefit to the economy?   Do you think investments in shipbuilding provide  greater benefit to the U.S. economy than popular alternatives?  Why?      (2) Do you think the economic benefit of the “life of the ship” should be considered,  beyond simply the benefit of the expenditures for construction itself (what about COTS  technology insertions, etc)?      (3) How can the indirect/induced  benefits be quantified?  (reference to Oxford Defense  Study helpful)      (4) What do you think is most convincing about economic arguments for more resources in  any particular industry?  (jobs, GDP growth,…) ?      (5) Do you think a study of local economic effects (barber shops, restaurants opening near  shipyards, for example) can be effective with national policy‐makers?    73 THIS PAGE INTENTIONALLY LEFT BLANK 74 APPENDIX B: FEDERAL RESERVE BOARD PROCEDURES Source: U.S Federal Reserve Board INDUSTRIAL PRODUCTION EXPLANATORY NOTES Coverage The industrial production (IP) index measures the real output of the manufacturing, mining, and electric and gas utilities industries; the reference period for the index is 2002 Manufacturing consists of those industries included in the North American Industry Classification System (NAICS) definition of manufacturing plus those industries–newspaper, periodical, book, and directory publishing plus logging–that have traditionally been considered to be manufacturing For the period since 1997, the total IP index has been constructed from 312 individual series based on the 2002 NAICS codes These individual series are classified in two ways: (1) market groups, and (2) industry groups Market groups consist of products and materials Total products are the aggregate of final products, such as consumer goods and equipment, and nonindustrial supplies (which are inputs to nonindustrial sectors) Materials are inputs in the manufacture of products Major industry groups include three-digit NAICS industries and aggregates of these industries for example, durable and nondurable manufacturing, mining, and utilities A complete description of the market and industry structures, including details regarding series classification, relative importance weights, and data sources, is available on the Board's web site Source Data On a monthly basis, the individual indexes of industrial production are constructed from two main types of source data: (1) output measured in physical units and (2) data on inputs to the production process, from which output is inferred Data on physical products, such as tons of steel or barrels of oil, are obtained from private trade associations and from government agencies; data of this type are used to estimate monthly IP wherever possible and appropriate Production indexes for a few industries are derived by dividing estimated nominal output (calculated using unit production and unit values or sales) by a corresponding Fisher price index; the most notable of these fall within the high-technology grouping and include computers, communications equipment, and semiconductors When suitable direct measures of product are not available, estimates of output are based on production-worker hours by industry Data on hours worked by production workers are collected in the monthly establishment survey conducted by the Bureau of Labor Statistics The factors used to convert inputs into estimates of production are based on historical relationships between the inputs and the comprehensive annual data used to benchmark the IP indexes; these factors also may be influenced by technological or cyclical developments The annual data used in benchmarking the individual IP indexes are constructed from a variety of source data, such as the quinquennial Censuses of Manufactures and Mineral Industries and the Annual Survey of Manufactures, prepared by the Bureau of the Census; the Minerals Yearbook, prepared by the United States Geological Survey of the Department of the Interior; and publications of the Department of Energy 75 Aggregation Methodology and Weights The aggregation method for the IP index is a version of the Fisher-ideal index formula (For a detailed discussion of the aggregation method, see the Federal Reserve Bulletins of February 1997 and March 2001.) In the IP index, series that measure the output of an individual industry are combined using weights derived from their proportion in the total value-added output of all industries The IP index, which extends back to 1919, is built as a chain-type index since 1972 The current formula for the growth in monthly IP (or any of the sub-aggregates) since 1972 is shown below An output index for month m is denoted by ImA for aggregate A and Im for each of its components The monthly price measure in the formula (pm) is interpolated from an annual series of value added divided by the average annual IP index The IP proportions (typically shown in the first column of the relevant tables in the G.17 release) are estimates of the industries' relative contributions to overall growth in the following year For example, the relative importance weight of the motor vehicles and parts industry is about percent If output in this industry increased 10 percent in a month, then this gain would boost growth in total IP by 8/10 percentage point (0.08 x 10% = 0.8%) To assist users with calculations, the Federal Reserve's web site provides supplemental monthly statistics that represent the exact proportionate contribution of a monthly change in a component index to the monthly change in the total index Timing The first estimate of output for a month is published around the 15th of the following month The estimate is preliminary (denoted by the superscript "p" in tables) and subject to revision in each of the subsequent five months as new source data become available (Revised estimates are denoted by the superscript "r" in tables.) For the first estimate of output for a given month, about 72 percent of the source data (in value-added terms) are available; the fraction of available source data increases to 86 percent for estimates in the second month that the estimate is published, 95 percent in the third month, 98 percent in the fourth month, 99 percent in the fifth month, and 99 percent in the sixth month Data availability by data type in late 2008 is summarized in the table below: 76 (Percent of value added in 2008) Month of estimate Availability of Monthly IP Data in Publication Window 1st 2nd 3rd 4th 5th 6th Type of Data Physical product 30 44 54 56 57 57 Production-worker hours 42 42 42 42 42 42 IP data received 72 86 95 98 99 99 IP data estimated 28 14 1 NOTE: The physical product group includes series based on either monthly or quarterly data As can be seen in the first row of the table, in the first month, a physical product indicator is available for about half of the series (in terms of value added) that ultimately are based on physical product data (30 percent out of a total of 57 percent) Of the 30 percent, about two-thirds (19 percent of total IP) include series that are derived from weekly physical product data and for which actual monthly data may lag up to several months On average, quarterly product data are received for the fourth estimate of industrial production Specifically, quarterly data are available for the third estimate of the last month of a quarter, the fourth estimate of the second month of a quarter, and the fifth estimate of the first month of a quarter Seasonal Adjustment Individual series are seasonally adjusted using Census X-12 ARIMA For series based on production-worker hours, the current seasonal factors were estimated with data through February 2009; for other series, the factors were estimated with data through at least September 2008 Series are pre-adjusted for the effects of holidays or business cycles when appropriate For the data since 1972, all seasonally adjusted aggregate indexes are calculated by aggregating the seasonally adjusted indexes of the individual series Reliability The average revision to the level of the total IP index, without regard to sign, between the first and the fourth estimates was 0.26 percent during the 1987-2008 period The average revision to the percent change in total IP, without regard to sign, from the first to the fourth estimates was 0.21 percentage point during the 1987-2008 period In most cases (about 85 percent), the direction of the change in output indicated by the first estimate for a given month is the same as that shown by the fourth estimate Rounding The published percent changes are calculated from unrounded indexes, and may not be the same as percent changes calculated from the rounded indexes shown in the release 77 UTILIZATION RATES CALCULATION METHOD Six basic steps are involved in calculating the utilization rates published by the Federal Reserve Step Implied end-of-year indexes of industrial capacity (ICAP) are constructed by dividing a production index (IP) by a utilization rate (U) obtained from a survey for an end-of-year period (t) [1] (1) ICAPt = IPt / Ut These ratios are expressed, like industrial production, as percentages of production in a base year, currently 2002, and give the general level and trend of the capacity estimates After an annual revision of industrial production, the capacity indexes must also be revised The implied capacity indexes will automatically incorporate revisions to production in the estimation of capacity Step The annual movements of the implied capacity indexes are refined to give consideration to alternative indicators of capacity changes; these alternatives include capacity data in physical units and estimates of capital input by industry [2] The Federal Reserve’s estimates of annual capacity at the most detailed level are derived from the fitted values of regressions that relate the implied capacity indexes to these alternative indicators; the regressions are designed to improve the year-to-year changes in the implied capacities but to leave their trends intact Specifically, for industries based on utilization rates from the QSPC, the logarithm of implied capacity is regressed on industry capital input (K), a deterministic trend (t), the age of the capital stock (A) (a proxy for embodied technological change), and occasional dummy variables (Di): For series based on physical data, an analogous regression is run in which the capital input measure is replaced with the measure of physical capacity and the age-of-capital variable is omitted The fitted values of the regressions are used as the estimates of industrial capacity Extrapolations of capacity beyond the latest survey year also are based on the estimated model (2), given the trend terms and estimates of capital input and related measures or updated estimates of capacity in physical volumes Step A monthly time series is formed by interpolating between the fourth-quarter baseline capacity indexes produced by the regression models The interpolation procedure allows the monthly rates of increase to change smoothly over time while maintaining the same fourth-quarter to fourth-quarter rates of increase as the baseline capacity indexes Step An adjustment may then be applied to estimates of capacity that appear to reflect short-term peak capacity rather than a sustainable level of maximum output This adjustment is most prominent in the capacity index for electricity generation, in which the 78 margin for summer peak loads is removed from the estimates implied by the physical data An adjustment may also be applied when data sources are changed, to achieve continuity and consistency with historical utilization rate levels Step The monthly capacity aggregates are constructed in three steps: (1) utilization aggregates are calculated on an annual basis through the most recent full year as capacityweighted aggregates of individual utilization rates; (2) the resulting annual utilization rate is then divided into the corresponding IP aggregate to calculate an annual capacity index; and (3) the annual capacity index is interpolated using an annually weighted Fisher index of its constituent monthly capacity series to derive the monthly capacity aggregate Step Utilization rates for the individual series and aggregates are calculated by dividing the pertinent monthly production index by the related capacity index Consistency A major aim is that the Federal Reserve utilization rates be consistent over time so that, for example, a rate of 85 percent means about the same degree of tightness that it meant in the past A major task for the Federal Reserve in developing reasonable and consistent time series of capacity and utilization is dealing with inconsistencies between the movements of the industrial production index and the survey-based utilization rates The McGraw-Hill/DRI Survey, now discontinued, was the primary source of manufacturing utilization rates for many years This was a survey of large companies that reported, on average, higher utilization rates than those reported by establishments covered by the annual Survey of Plant Capacity (the primary source of factory operating rates through 2006, after which it was discontinued) Adjustments have been made to keep the industry utilization rates currently reported by the Federal Reserve roughly in line with rates formerly reported by McGraw-Hill As a consequence, the rates reported by the Federal Reserve tend to be higher than the rates reported in the Census utilization surveys Weights Although each utilization rate is the result of dividing an IP series by a corresponding capacity index, aggregate utilization rates are equivalent to combinations of individual utilization rates aggregated with proportions that reflect current capacity levels of output valued in current-period value added per unit of actual output Perspective Over the 1972-2008 period, the average total industry utilization rate is 80.9 percent; for manufacturing, the average factory operating rate has been 79.6 percent Industrial plants usually operate at capacity utilization rates that are well below 100 percent: none of the broad aggregates has ever reached 100 percent For total industry and total manufacturing, utilization rates have exceeded 90 percent only in wartime 79 THIS PAGE INTENTIONALLY LEFT BLANK 80 INITIAL DISTRIBUTION LIST Defense Technical Information Center Ft Belvoir, VA Dudley Knox Library Naval Postgraduate School Monterey, CA RADM Stephen Johnson, USN Strategic Systems Programs Arlington, VA Mr Jonathan Wright Naval Sea Systems Command 05C Washington, DC Ms Amy Praeger American Shipbuilding Association Washington, DC RADM William Hilarides Program Executive Officer, Submarines Washington, DC 81